Summary

While this sounds like a good problem to have - in fact, it is a significant contributor to its discount to tangible book value.

Citi has to deliver meaningfully in CCAR 2016 or else breaking up the firm will become a real option.

In this article, I will highlight the various constraints and possible outcomes.

Citigroup (NYSE:C) generates substantial capital from its net income, DTA utilization and disposal of businesses and assets. Unfortunately, Citi has not been able to return meaningful capital to its shareholders due to CCAR constraints.

As can be seen from the below Q4 2015 earnings deck's extract -in 2015, Citi generated in excess of $20 billion of capital and returned ~$6 billion in the form of buybacks and dividends.

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Not surprisingly, its capital ratios increased substantially over recent times:

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At the end of Q4 2015, Citi has a CET1 ratio of 12% on a fully phased-in Basel III basis.

Citi's minimum capital requirements

On a fully implemented basis, Citi's minimum capital requirement is 10.0% (including a G-SIB capital surcharge of 3.0%). Citi's CFO disclosed on the Q4 2015 fixed income call, that Citi has now moved to a lower a capital surcharge. This is a very welcome news to shareholders.

As per recent management guidance, Citi expects to operate with 50-100 basis points of a management buffer - hence, optimally it should operate with a CET1 ratio of 10.5%-11.0%.

Citi is already operating with a CET1 ratio of 12%, which will likely further increase as it generates huge amount of excess capital.

Mr Corbat's denominator problem

Mr Corbat refers to the over-capitalization issue as the "denominator problem" - in other words, if Citi ends up holding more capital than optimal, its ROE metric suffers. It is simple math that applies to the ROE formula - as Equity goes up (denominator) while Return (numerator) stays constant, ROE decreases.

As a point of reference, Bank Of America as of Q4 2015 operates with a CET1 ratio of 9.8%. Since Citi operates with a 12% CET1 ratio, it needs to earn 20%+ more than BAC to achieve the same ROE outcome (all else being equal).

This is a significant drag on Citi's return and Mr Corbat clearly acknowledges this:

We recognize our capital generating capacity and power and we've got to position the institution and affirm to continue to ramp up and more meaningfully be returning capital to our shareholders. Otherwise we're just going to be faced with a denominator problem.

So what is stopping Citi returning more capital?

It is Citi's torrid history with the Fed's annual stress tests (known as CCAR). Citi failed its CCAR submission in 2014 due to qualitative concerns raised by the Fed and was prevented from returning any capital. In 2015, the capital ask was a very modest one. Consequently, Citi has accumulated more capital that it should otherwise optimally would want to hold or knows what to do with.

If one assumes that Citi will generate an additional $20 billion of capital in 2016 and currently carries an excess of ~$15 billion - its total current capacity is approximately $35 billion.

Don't hold your breath - Citi will not request anywhere near that amount. So the over-capitalization will likely persist for several more years.

Clearly, in the last 12 months Citi released substantial additional quantitative CCAR capacity (both in terms of lower projected loan losses and build up of excess capital). As such, Mr Corbat has made some reasonably bullish statements in relation to CCAR submission:

So Betsy, what we do know is we know our numbers, we know our ratios. You've seen our capital generating capacity net of approximately $6 billion capital return. We still generated 140 basis points of CE Tier 1 in the course of '15 and we think we continue to have significant capital generating power going forward.

So we feel like from where ratios are, we're coming into this year's exercise or this year's submission in a stronger place. We also know that we're going to be using - the industry is going to be using a Gen-4 (Jan 4) balance sheet. We think that's for us a good balance sheet, but what we don't know is we don't know the scenarios.

Time to get aggressive on CCAR

Citigroup paid its dues in the 2015 CCAR process with a modest capital return ask. It was the correct decision for the time - Citi needed to fix their qualitative failures and more importantly rebuild relationships with their regulators.

In 2016, Citigroup needs to submit an aggressive capital return ask (subject of course to scenarios and what is allowed by the quantitative model). The alternative will likely mean that Citi will finish 2016 with a CET1 ratio close to 13% or above, compared with an optimal final state of 11%.

This effectively means (all else being equal) that Citi will continue to trade at a substantial discount to TBV for the foreseeable future.

What are the other alternatives?

If the mountain won't come to Citi, then Citi must go the mountain.

In other words, if the Fed does not allow Citi to return capital - to release shareholders' value, Citi has to either grow or shrink.

The growth option includes organic and inorganic acquisitions such as Costco, which will absorb RWA and provide attractive ROA and ROE returns. Of course, any acquisitions needs to be very disciplined and ensure it makes sense from all perspectives (Leverage, CCAR stressed values, G-SIB, Economic Capital models etc).

The other option is shrinking and selling assets that increase shareholders value and do away with the conglomerate discount. For example, businesses that are valued by the market at multiples of TBV and utilize significant CCAR and G-SIB capacity - I can think of a couple.

Final thoughts

Citi's denominator problem is not going away any time soon. Currently, Mr Corbat is planning to chip at it by increasing capital returns and growing certain businesses (Prime Finance, Credit Cards). Note there are also substantial risks in late-cycle investing in businesses such as U.S. credit cards.

Still Citi's strategy may not be quick enough to absorb the capital generated - Citi could very well find itself with a CET1 ratio of ~13%. In other words, 2% of capital that sits idly on the balance sheet and for which Mr Market ascribes very little value to.

Citi's 2016 CCAR submission will be telling. If Mr Corbat cannot deliver a bullish capital ask - then I expect a shareholders' revolt and rightly so.

Breaking up Citi will likely become a viable option and activist investors will surely get involved. For avoidance of doubt, I do not propose restructuring the Institutional Client Group (NYSE:ICG) rather, the focus should be on the Consumer side. It could well be simple as selling certain businesses for ~$20-$30 billion (at above TBV), consume DTA on taxable gains, reduce projected CCAR losses and use proceeds and other generated capital (~$40-$60 billion in total) to buyback stock aggressively (note current MV of Citi is ~125 billion).

Mr Carl Ichan may already be combing through Citi's financials.

I will provide my guidance on CCAR capital ask in my next articles - specifically, assess the Fed scenarios as they apply to the large U.S. banks - please add me as a "real-time follower" if this is of interest.

I cover U.S., European, Asian, Canadian and Australian large-cap banks, identifying long and short opportunities. If interested in the topic, feel free to add me as a "real-time follower" or message me if interested in a specific banking name.

Disclosure:I am/we are long C.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.